Student Loan: A New Crisis To Come?

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• in: News
• Written by: Charlotte Harper

In the United States, at a time when the Democratic Party is championing relief for borrowers from the growing burden of student debt, Donald Trump and the Department of Education are considering the privatization of this debt, perceived as a threat to the public finances of the federal state. Who are the actors on the front line in this case? Above all, to what underlying risks does this phenomenon expose the financial sector?

In the midst of the campaign for the spring 2020 primaries, the contenders of the Democratic camp compete in imagination to propose a response to the social crisis caused by the steady increase in the indebtedness of higher education students. When Vermont senator Bernie Sanders promises to completely erase student debt by financing it by a “tax on Wall Street”, Massachusetts senator Elizabeth Warren intends to cancel it at 95% by taxing the big fortunes. Other more moderate candidates propose to adapt tuition fees more to the income of students and their families.

In addition to the essential question of the inequalities raised by this subject of student debt, beyond the economic concerns linked to the draining of part of the income of many Americans forced to repay their student loans (to the detriment of household consumption), c It is the financial dimension of this phenomenon that is of primary interest.

A student debt that has exploded since 2008In 2012, Barack Obama claimed that he had finished repaying his student loan in 2004, barely four years before his election as President of the United States at the age of 47. The case of the 44th American president, a graduate of the very prestigious Harvard University and Columbia University, is emblematic of what the majority of Americans who have completed higher education experience, whether in private universities like Harvard or public ones. The tuition fees of the latter are de facto indexed to those charged by the former, in a context of heightened competition which pushes them to want to offer services similar to those offered by the most renowned private universities. This dynamic is organically the first source of continuous increase in tuition fees since the 1980s.

Clearly, the 2008 crisis played an accelerating role in this upward trend. Indeed, the Bureau of Economic Analysis (BEA) of the Department of Commerce estimates at 9% the fall in tax revenues of local authorities and American states between 2008 and 2009, resulting in a tightening of their expenditure, in particular in the financing of public universities, which represent 38% of the 4,300 colleges in the country. At the national level, the share of this funding thus fell from 27% to 18% between 2008 and 2012. This explains the 63% increase in tuition fees measured by the US Bureau of Labor Statistics (BLS) between 2006 and 2016.

If so, why did university enrollment pick up again after 2008? For Jaison Abel and Richard Deitz[1], of the Federal Reserve Bank of New York, the answer is simple: even if the 2008 crisis led borrowers to accept lower-paying jobs, the profitability of an undergraduate course university cycle remains important for students. Moreover, the BLS establishes a positive correlation between the unemployment rate and the number of enrollments in higher education. In other words, each recession is accompanied by an increase in the number of students enrolled in university, despite the decline in household income.

Result, nearly 45 million Americans are now subscribers of a student loan, for a total amount of 1600 billion dollars. This corresponds to a 142% increase in student debt since 2008, far exceeding the growth of other types of credit in the United States over the same period. In 2005, a student in debt left college with an average debt of $20,000, up from $37,000 less than fifteen years later, with an average repayment period of 19 years. Note that loans of more than $100,000 concern only 5% of borrowers.

This spectacular increase in student debt is part of an upward trend in US household debt. This had decreased significantly after 2008, before experiencing a recovery from 2013 in a context of low interest rates, until it exceeded the level of the 3rd 2008 in the 2nd 2014, to finish today at more than 13,670 billion dollars, according to the New York Fed. This equates to 103% of US GDP, compared to 86% in the UK and 58% in France.

While US student debt now represents only 12% of this household debt, far behind real estate debt, which remains at the top of the rankings despite the 2008 earthquake, this share has more than doubled since 2008, when that of debt real estate lost nearly 10 points. Student debt thus ranks second among the different types of credit granted to American households, behind home loans, but ahead of car loans and loans contracted by credit card.

It remains to be seen what risks are generated by this debt and which players are its depositaries.

The risk of collapse is currently not carried by the market
Since the mid-1990s, the federal government has directly issued student loans, whereas until then it was content to guarantee their repayment (by dictating to credit institutions favorable conditions for borrowers). From 2010, with the Obama reforms, he went so far as to grant himself a quasi-monopoly on the issuance of these loans, to the detriment of the private sector.

Thus, the high risk of default of 11.5% on these loans weighs above all on public finances. Indeed, in its 2016 annual report, the US Treasury Department pointed out that student debt constituted 31% of the assets of the US government, which to date has more than $1.45 trillion in student debt, or more than 90 % of this debt.

In the event of an economic downturn, a source of an explosion in the default rate, the risk would be massively projected onto public finances already crumbling under the expenditures operated by the Trump administration, in particular with its policy of massive tax cuts in 2017[ 2]. As a result, the public deficit in the United States returned to its 2012 level last year, at 3.9% of GDP. The federal government’s public finances are therefore particularly exposed to the risk of an economic downturn, particularly in a context of trade tensions with China.

Thus, the risk is currently not borne by the banks and the market. Indeed, a note published by the Banque de France in 2014 pointed out that American student debt did not directly threaten the banking system, insofar as it was mainly guaranteed by the federal government and not very securitized (20% of debts only).

Is the situation different today? Basically, no. The government still holds and insures the majority of the debts, the default rate remains stable and securitization remains marginal and has even been declining since 2010. Nothing seems to have changed significantly. With one difference: the political and regulatory environment. This is precisely where the future risk for the banking sector and investors lies.

Debt Privatization Project and Risk Deferral
If the 2008 crisis had been followed by a vast movement of banking regulation (the Dodd-Frank Act, signed by Obama in 2010, translated the American commitments made within the framework of the G20 in terms of financial regulation), the end of the The 2010 decade has been marked by the opposite trend since the arrival of Donald Trump at the White House.

The weakening of the Dodd-Frank law was ratified in May 2018 through the Economic Growth, Regulatory Relief and Consumer Protection Act passed by both chambers of the US Congress, which thus validated the decrees signed the previous year by the current tenant of the White House[3] in order to significantly restrict the number of banks subject to federal regulation. These include raising the threshold of assets beyond which a bank is considered systemic from $50 billion to $250 billion, which amounts to reducing the number of financial institutions subject to restrictive prudential ratios on their funds clean.

It is in this context of banking deregulation that, on May 1, the Wall Street Journal published information according to which the Department of Education had hired the consulting firm McKinsey & Company to carry out an audit of the student debt assets held by the federal government. The stated objective is clear: to assess the consequences of an increase in the default rate on public finances, to determine what the benefits would be of a partial or total privatization of these assets and to set the “fair” price of such a sale. to private organizations.

In the past, several senior Trump administration officials, in particular current Education Secretary Betsy DeVos, have spoken out in favor of privatizing this debt. The resulting reasoning consists in affirming that it is better to transfer the risk to the market and the banking system, which are supposed to manage the weight of this debt more optimally, rather than carrying out a socialization of risks, i.e. to put the risk on the public finances of the federal government and therefore on the American taxpayer.

Betsy DeVos, who declared in November 2018 that “the state’s monopoly [on the issuance of student debt] is costly for taxpayers without solving the problem of students”[4], was thus targeting the measures taken by the Obama administration in 2010 to strengthen the role of the federal state in issuing this type of loan.

Legally, such privatization is possible. Indeed, a provision of the Higher Education Act (HEA), a law enacted in 1965 under the Johnson administration as part of its so-called “Great Society” policy to fight inequality and poverty, authorizes the Secretary of Education to privatize student loans, if the negotiated terms are “in the best interest of the United States”.

Obviously, such a prospect delights the sector organizations already present in the student debt niche, mainly Sallie Mae, Wells Fargo and Discover Financial Services, which currently represent less than 8% of student loans granted in the United States. Thus, we note that the Sallie Mae[5] share soared by 62% in the month following the election of Donald Trump, on November 4, 2016. Moreover, the sector remains massively under-occupied, as underlined the absence of major players such as JP Morgan in this niche.

Such an opening of the student loan industry to the private sector would de facto imply a vast movement of securitization of these assets, which consists of transforming claims into financial securities that can be exchanged on the capital market. In the case of student loans, securitization takes the form of SLABS (Student Loan Asset-Backed Securities). The advantage of securitization for financial institutions is to remove these receivables from their balance sheet and thus improve their solvency ratios in order to be able to grant new loans. The advantage for investors (banks, hedge funds, pension funds, etc.) who buy these securities is the prospect of a high return. At the global level, the risk is supposed to be limited, as it is spread over a large number of investors and therefore absorbed in the event of a shock.

However, if the risk materializes massively, the collapse will be potentially violent, all the more so if the quality of the securities has been incorrectly assessed. Here we find one of the mechanisms at the heart of the outbreak of the 2008 financial crisis. In 2014, the federal government’s guarantee on these loans provided 81% of SLABS with a rating above AA[6]. But what about credit risk in the event of privatization?

The worst-case scenario in the event of total securitization Contrary to 2008, the risk is in reality not that of the bursting of the student loan “bubble”. The latter, unlike mortgage loans whose value had collapsed in 2007, are not strictly speaking based on an asset, they are based on the price of a diploma. Admittedly, in purely economic terms, we can consider that borrowers invest in a diploma by borrowing in order to be able to “buy” it and obtain a return on investment through their future remuneration. However, it would not make much sense to speak of “overvaluation” of the diploma because its price (the tuition fees) depends on too many factors that escape the laws of the market. In this case, there is therefore no need to speak of a bubble. No, the risk is elsewhere.

It comes from the potential explosion of the default rate of borrowers on these loans. It is on this condition that the value of claims would collapse, to the detriment of their owners (the creditors), on the same pattern as in 2007-2008.

Two main credible causes of such an earthquake would be, on the one hand, a sharp fall in the income of indebted households, in a context of economic downturn and, on the other hand, the increase in the interest rates demanded by the financial institutions. private. While the rates for loans insured by the federal state amount to an average of 4%, those practiced by the private sector amount to more than 10%. Furthermore, privatization would lead to the end of the advantages offered by the federal government in terms of debt rescheduling and the temporary suspension of repayments in the event of household difficulties.

According to Judith Scott-Clayton, a professor at Columbia University, in a report published by the Brookings Institution in January 2018, the default rate on student loans could reach 40% by 2023, against an average of 11.5%. currently, a stable figure since 2014. By way of comparison, the default rate on subprime loans exceeded 15% in the summer of 2007.

The risk of propagation to the entire financial sector lies in the scattering of this possible securitized debt pension funds, hedge funds, and above all banks, which raises the question of the solidity of their own funds, which they lacked in 2008. It should be remembered that the reforms of the current administration are not going in the direction of a strengthening of these own funds, on the contrary. What would be the effects of a massive holding of risky student debt securities by an institution such as Wells Fargo (the fourth-largest American bank by assets) in the event of an explosion in the default rate? The effects are difficult to measure, but the Lehman Brothers case is a milestone in this area. However, prudential rules have evolved and the latest stress test in June 2019 showed that most major US banks had a capital ratio generally above 10% of their assets. Nothing to do with the 3% of Lehman Brothers at the height of the crisis, eleven years ago. However, caution is still in order.

To remove any ambiguity, it is not a question of analyzing every financial situation in the light of the 2008 crisis, but in the case that interests us, such a comparison is of interest, if only in terms of orders of magnitude.

In this case, the current amounts of private student debt remain much lower than those involved in the collapse of 2008. According to the Banque de France, the exposure of subprimes at the height of the bubble was dollars in 2007, against 100 billion today for the student loans of 1.4 million borrowers managed by the private sector, according to Bloomberg. On the other hand, if the federal debt were entirely privatized and securitized tomorrow, we would obtain an outstanding amount of 1600 billion dollars…

However, let’s not forget that the student debt is mechanically pushed upwards by the ratchet effect of the increase in tuition. In other words, the latter are rigid downwards, for the reasons cited above (competition between universities, fall in public funding and increase in demand for higher education since 2008). If we look at the eleven years that have elapsed since 2008, we obtain an average annual growth rate for this debt of 8.4%. Assuming that the trend continues at the same rate over the next six years, we obtain a projected outstanding student debt of nearly $2.6 trillion in 2025, i.e. double the outstanding amount of subprime loans in 2007.

Also, in the event of privatization and securitization of student debt, the latter would run less risk of being an intrinsic source of liquidity or even financial crisis than an accelerating factor, a major transmission belt of an economic crisis towards the financial sector. To be continued…

[1] Jaison R. Abel & Richard Deitz, “Do the Benefits of College Still Outweight the Costs?”, Issues in Economics and Finance (Vol. 20 No. 3, 2014).

[2] Tax reduction estimated by the American Congress at 1450 billion dollars over 10 years, ie an equivalent increase in the public deficit over this period.

[3] January 30 and February 3, 2017.

[4] “The government monopoly has proven costly to taxpayers and it hasn’t been a panacea for students either” (November 27th, 2018).

[5] Nickname of SLM Corporation (formerly Student Loan Marketing Association), listed on NASDAQ.

[6] According to the Standard & Poor’s (S&P) rating grid.